Head to head: are annuities worthwhile?

Annuities are very controversial.

Many people resent handing over a large part of their pension pot in order to buy an income in retirement. But some suggest annuities are the best way to ensure a comfortable old age.

Two experts argue the case for and against the annuity system.

Jonathan Fry, director, Jonathan Fry & Co

Jonathan Fry thinks annuities have a big role

Most people who retire with a lump sum to invest in providing a regular income throughout their retirement look to the purchase of an annuity for their full pension provision or as part of their investment portfolio.

And with good reason.

Annuities offer a safe and secure haven for a pensions nest-egg built up through a working lifetime of regular contributions.

They come with the flexibility to secure a level income, an inflation-linked income or, for the more courageous, an index-linked income, the fortunes of which are dependent to some degree on the performance of the stock market.

One of the criticisms levelled at annuities is that they are locked on purchase and can't be refunded or amended.

That is true, but having one's pension provision fixed at the age of 65, or later, offers many people the peace of mind they are seeking when they retire.

How many pensioners have either the desire or, later in life, the capacity to continually review their pension management in order to secure the most favourable return?

And yes, annuities do carry some modest costs in the event of an early death, but who plans for that when faced with planning for a hopefully long and active retirement? And, quite honestly, who should?

A level annuity, paying out a fixed monthly amount until death, is the favoured option of 80 per cent of purchasers.

It must be appreciated that this kind of annuity will not increase throughout its term, but you can expect a level annuity to offer an annual payout in excess of six per cent of the lump sum investment, a return that should remain respectable for several years to come.

Alternatively, an inflation-linked annuity will offer a return linked to the retail price index or at a fixed rate growth of about three per cent. In terms of money paid, the inflation-linked annuity will cross over the level annuity after about 20 years.

Little wonder, therefore, that the level annuity is preferred by pensioners who wish to receive a higher pension in their early years of retirement, reducing as their life expectancy and financial needs diminish.

For those seeking a higher return for a higher risk, annuities linked to investment funds provide lower payments to start with but have the potential to grow substantially if the underlying funds, containing a mixture of shares, perform well on a buoyant stock market.

Such annuities provide an excellent option for pensioners who may have other sources of income in their portfolio of savings.

Others, looking for a more secure annuity with a smaller degree of adventure, should consider an annuity linked to a with-profits fund, which invests in a mixture of equities, fixed interest and commercial property.

So, in conclusion, annuities are not the straitjacket portrayed by my opposing commentator.

They offer choice, flexibility to individuals' circumstances, peace of mind and the opportunity for a degree of speculation.

They should not be dismissed.

Geoff Tresman, Chairman of financial advice firm Punter Southall

Supporters of annuities advocate the risk-free advantages of converting your retirement pot into a guaranteed life income.

But this overlooks an important issue: the process of converting your pot is actually quite risky.

Insurance companies calculate annuities based on a combination of gilt yields and interest rates.

Can annuities help pay for a comfortable old age?

So if you buy one when interest rates are low, such as now, you get much lower returns than if you buy one at time when they are high, such as 15 years ago.

Annuities are inflexible.

Once you decide on your structure, it can never be changed again.

Many sensibly give up part of their initial pension in order to provide for their spouse.

But if the spouse dies before the annuitant, it will never be paid, and the annuitant gets a lower pension for life.

Likewise, to protect against future inflation pressures you might opt for a pension that increases annually.

But an automatic 3% annual increase will mean a starting pension up to a third lower - taking 12 years to match a non-inflation linked pension and making the 65-year-old buyer almost 90 before breaking even overall.

Buyers have limited options to protect both their spouse and their estate if they die early: buy a spouse's pension, build in a guarantee period of payment (often five or 10 years), or opt for 50% of their pension to continue after death to their spouse (assuming the spouse survives).

But limited as these options are, worse is that in the event of an early death, buyers are really subsidising the annuities of people they have never met.

Supporters of annuities claim that annuity buyers benefit from a "mortality subsidy".

Perhaps this was relevant in the days when people were forced to buy an annuity, irrespective of their state of health.

But nowadays people who are in ill-health or are terminally ill are not in the same annuity pool. They often seek special terms to qualify for separate and higher annuity rates.

There is still a place for annuities for people who are confident of receiving value for money and with no need to maximise returns or who wish to be completely risk-averse - but this group is shrinking.

Sadly, this sorry state of affairs will do nothing to rebuild confidence in pensions at a much-needed time.

The opinions expressed are those of the authors and are not held by the BBC unless specifically stated. The material is for general information only and does not constitute investment, tax, legal or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.